UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended May 22, 2004
OR
For the transition period from to
Commission file number 1-303
THE KROGER CO.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1014 Vine Street, Cincinnati, OH 45202
(Address of principal executive offices)
(Zip Code)
(513) 762-4000
(Registrant’s telephone number, including area code)
Unchanged
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨.
There were 739,105,212 shares of Common Stock ($1 par value) outstanding as of June 23, 2004.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
CONSOLIDATED STATEMENTS OF EARNINGS
(in millions, except per share amounts)
(unaudited)
Sales
Merchandise costs, including advertising, warehousing, and transportation
Operating, general and administrative
Rent
Depreciation and amortization
Earnings from operations
Interest expense
Earnings before income tax expense
Income tax expense
Net earnings
Net earnings per basic common share
Average number of common shares used in basic calculation
Net earnings per diluted common share
Average number of common shares used in diluted calculation
The accompanying notes are an integral part of the Consolidated Financial Statements.
CONSOLIDATED BALANCE SHEETS
ASSETS
Current assets
Cash, including temporary cash investments of $11 in 2004 and $15 in 2003
Store deposits in-transit (Note 1)
Receivables
Inventory
Prefunded employee benefits
Prepaid and other current assets
Total current assets
Property, plant and equipment, net
Goodwill
Fair value interest rate hedges (Note 12)
Other assets and investments
Total Assets
LIABILITIES
Current liabilities
Current portion of long-term debt, at face value, including obligations under capital leases
Accounts payable
Accrued salaries and wages
Deferred income taxes
Other current liabilities
Total current liabilities
Long-term debt including obligations under capital leases
Long-term debt, at face value, including obligations under capital leases
Adjustment to reflect fair value interest rate hedges (Note 12)
Other long-term liabilities
Total Liabilities
Commitments and Contingencies (Note 11)
SHAREOWNERS’ EQUITY
Preferred stock, $100 par, 5 shares authorized and unissued
Common stock, $1 par, 1,000 shares authorized: 916 shares issued in 2004 and 913 shares issued in 2003
Additional paid-in capital
Accumulated other comprehensive loss
Accumulated earnings
Common stock in treasury, at cost, 178 shares in 2004 and 170 shares in 2003
Total Shareowners’ Equity
Total Liabilities and Shareowners’ Equity
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions and unaudited)
May 24,
2003
Cash Flows From Operating Activities:
Adjustments to reconcile net earnings to net cash provided by operating activities:
LIFO charge
Other
Changes in operating assets and liabilities net of effects from acquisitions of businesses:
Inventories
Store deposits in-transit
Prepaid expenses
Accrued expenses
Accrued income taxes
Contribution to company-sponsored pension plan
Net cash provided by operating activities
Cash Flows From Investing Activities:
Capital expenditures, excluding acquisitions
Proceeds from sale of assets
Payments for acquisitions, net of cash acquired
Net cash used by investing activities
Cash Flows From Financing Activities:
Reductions in long-term debt
Financing charges incurred
Increase (decrease) in book overdrafts
Proceeds from interest rate swap terminations
Proceeds from issuance of capital stock
Treasury stock purchases
Net cash used by financing activities
Net decrease in cash and temporary cash investments
Cash and temporary cash investments:
Beginning of year
End of quarter
Supplemental disclosure of cash flow information:
Cash paid during the year for interest
Cash paid (refunded) during the year for income taxes
Non-cash changes related to purchase acquisitions:
Fair value of assets acquired
Goodwill recorded
Liabilities assumed
NOTES TO CONSOLIDATED FINANCIALSTATEMENTS
All amounts are in millions except per share amounts.
Certain prior-year amounts have been reclassified to conform to current-year presentation.
1. ACCOUNTINGPOLICIES
Basis of Presentation and Principles of Consolidation
The accompanying financial statements include the consolidated accounts of The Kroger Co. and its subsidiaries. The January 31, 2004 balance sheet was derived from audited financial statements and, due to its summary nature, does not include all disclosures required by generally accepted accounting principles (“GAAP”). Significant intercompany transactions and balances have been eliminated. References to the “Company” in these Consolidated Financial Statements mean the consolidated company.
In the opinion of management, the accompanying unaudited Consolidated Financial Statements include all normal, recurring adjustments that are necessary for a fair presentation of results of operations for such periods but should not be considered as indicative of results for a full year. The financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted, pursuant to SEC regulations. Accordingly, the accompanying consolidated financial statements should be read in conjunction with the fiscal 2003 Annual Report on Form 10-K of The Kroger Co. filed with the SEC on April 14, 2004, as amended.
The unaudited information included in the Consolidated Financial Statements for the first quarters ended May 22, 2004 and May 24, 2003 include the results of operations of the Company for the 16-week period then ended.
Store Closing Costs
All closed store liabilities related to exit or disposal activities initiated after December 31, 2002, are accounted for in accordance with Statement on Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The Company provides for closed store liabilities relating to the present value of the estimated remaining noncancellable lease payments after the closing date, net of estimated subtenant income. The Company estimates the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. The closed store lease liabilities usually are paid over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily relate to changes in subtenant income and lease buyouts. Adjustments are made for changes in estimates in the period in which the change becomes known. Store closing liabilities are reviewed quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs, or that no longer is needed for its originally intended purpose, is adjusted to income in the proper period.
Owned stores held for disposal are reduced to their estimated net realizable value. Costs to reduce the carrying values of property, equipment and leasehold improvements are accounted for in accordance with the Company’s policy on impairment of long-lived assets. Inventory write-downs, if any, in connection with store closings, are classified in “Merchandise costs.” Costs to transfer inventory and equipment from closed stores are expensed as incurred.
Stock Option Plans
The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations to account for its stock option plans. The Company grants options for common stock at an option price equal to the fair market value of the stock at the date of the grant. Accordingly, the Company does not record stock-based compensation expense for these options. The Company also makes restricted stock awards. Compensation expense included in net earnings for restricted stock awards totaled approximately $3 and $2, after-tax, for the first quarter of 2004 and 2003, respectively. The Company’s stock option plans are more fully described in the Company’s fiscal 2003 Annual Report on Form 10-K.
The following table illustrates the effect on net earnings, net earnings per basic common share and net earnings per diluted common share as if compensation cost for all options had been determined based on the fair market value recognition provision of SFAS No. 123, “Accounting for Stock-Based Compensation:”
Net earnings, as reported
Add: Stock-based compensation expense included in net earnings, net of income tax benefits
Subtract: Total stock-based compensation expense determined under fair value method for all awards, net of income tax benefits
Pro forma net earnings
Net earnings per basic common share, as reported
Pro forma earnings per basic common share
Shares used in basic calculation
Net earnings per diluted common share, as reported
Pro forma earnings per diluted common share
Shares used in diluted calculation
Store Deposits In-Transit
Store deposits in-transit generally represent funds deposited to the Company’s bank accounts at the end of the quarter related to sales, a majority of which were paid for with credit cards and checks, to which the Company does not have immediate access. In previous quarters, these items were netted against accounts payable. The table below shows the balance of store deposits in-transit and accounts payable, as reclassified to conform with current year presentation, for the current and prior four quarters.
Quarter 1, 2003
Quarter 2, 2003
Quarter 3, 2003
Quarter 4, 2003
Quarter 1, 2004
2. MERGER-RELATED COSTS
The Company is continuing the process of implementing its integration plan related to recent mergers. The following table is a summary of the changes in accruals related to various business combinations:
Balance at January 31, 2004
Additions
Payments
Balance at May 22, 2004
The $60 liability for facility closure costs primarily represents the present value of lease obligations remaining through 2019 for locations closed in California prior to the Fred Meyer merger. The $14 liability relates to a charitable contribution required as a result of the Fred Meyer merger. The Company is required to complete this payment by May 2006.
3. RESTRUCTURING CHARGES AND RELATEDITEMS
Restructuring charges
On December 11, 2001, the Company outlined a Strategic Growth Plan (“Plan”) to support additional investment in its core business to increase sales and market share. The following table summarizes the changes in the balances of liabilities associated with the Plan:
Facility
Closure Costs
Balance at January 1, 2004
The $5 liability for facility closure costs relates to the present value of lease obligations remaining through 2009 related to the consolidation of the Company’s Nashville division office.
Store closing liabilities
In 2001 and 2000, the Company implemented two distinct, formalized plans that coordinated the closings of several locations over relatively short periods of time. The following table summarizes the changes in the balances of the liabilities:
Balances at January 31, 2004
Lease liabilities recorded
Balances at May 22, 2004
4. GOODWILL, NET
The following table summarizes the changes in the Company’s net goodwill balance:
Purchase accounting adjustments in accordance with SFAS No. 141
5. COMPREHENSIVEINCOME
Comprehensive income is as follows:
Reclassification adjustment for losses included in net earnings, net of tax (1)
Unrealized gain (loss) on hedging activities, net of tax (2)
Comprehensive income
During 2003, other comprehensive income consisted of reclassifications of previously deferred losses on cash flow hedges into net earnings as well as market value adjustments to reflect cash flow hedges at fair value as of the respective balance sheet dates.
6. BENEFIT PLANS
The following table provides the components of net periodic benefit costs for the first quarters of 2004 and 2003:
Components of net periodic benefit cost:
Service cost
Interest cost
Expected return on plan assets
Amortization of:
Transition asset
Prior service cost
Actuarial (gain) loss
Net periodic benefit cost
7. INCOMETAXES
The effective income tax rate was 36.9% for the first quarter of 2004 and 37.5% for the first quarter of 2003. The effective income tax rate differed from federal statutory rate primarily because of the effect of state taxes and open items with various taxing authorities.
8. EARNINGS PER COMMONSHARE
Earnings per basic common share equals net earnings divided by the weighted average number of common shares outstanding. Earnings per diluted common share equals net earnings divided by the weighted average number of common shares outstanding, after giving effect to dilutive stock options and warrants.
The following table provides a reconciliation of earnings before the cumulative effect of an accounting change and shares used in calculating earnings per basic common share to those used in calculating earnings per diluted common share:
First Quarter Ended
May 22, 2004
May 24, 2003
Earnings per basic common share
Dilutive effect of stock options and warrants
Earnings per diluted common share
The Company had options outstanding for approximately 27 shares and 43 shares during the first quarters of 2004 and 2003, respectively, that were excluded from the computations of earnings per diluted common share because their inclusion would have had an anti-dilutive effect on earnings per share.
9. RECENTLY ISSUED ACCOUNTING STANDARDS
FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” was issued in January of 2003 and revised in December 2003. FIN 46 provides guidance relating to the identification of, and financial reporting for, variable-interest entities, as defined in the Interpretation. FIN 46 is effective for all variable-interest entities created after January 31, 2003. For any variable-interest entities created prior to February 1, 2003, FIN 46 became effective on February 1, 2004, the beginning of the Company’s first quarter of 2004, unless earlier adopted, except for entities designated as special purpose entities for which the effective date was the fourth quarter of 2003. In the fourth quarter of 2003, the Company adopted FIN 46 for an unaffiliated mortgagor of certain of the Company’s properties.
In May 2004, the FASB issued Staff Position (“FSP”) No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” FSP No. 106-2 supersedes FSP No. 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” and provides guidance on the accounting, disclosure and transition related to the Prescription Drug Act. FSP No. 106-2 will be effective for the first interim period beginning after June 15, 2004. The Company will continue to investigate the effect of FSP No. 106-2’s initial recognition, measurement and disclosure requirements on its Consolidated Financial Statements. The Company does not expect adoption of FSP No. 106-2 to have a material effect on its Consolidated Financial Statements.
In November 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-10, “Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers.” Issue No. 03-10 addresses the accounting for manufacturer sales incentives offered directly to consumers, including manufacturer coupons. EITF Issue No. 03-10 became effective for the Company on February 1, 2004, the beginning of its first quarter of 2004. Adoption of EITF Issue No. 03-10 reduced the Company’s sales and merchandise costs by $17.9 during the first quarter of 2004.
10. GUARANTOR SUBSIDIARIES
The Company’s outstanding public debt (the “Guaranteed Notes”) is jointly and severally, fully and unconditionally guaranteed by The Kroger Co. and certain of its subsidiaries (the “Guarantor Subsidiaries”). At May 22, 2004, a total of approximately $6.8 billion of Guaranteed Notes were outstanding. The Guarantor Subsidiaries and non-guarantor subsidiaries are direct or indirect wholly owned subsidiaries of The Kroger Co. Separate financial statements of The Kroger Co. and each of the Guarantor Subsidiaries are not presented because the guarantees are full and unconditional and the Guarantor Subsidiaries are jointly and severally liable. The Company believes that separate financial statements and other disclosures concerning the Guarantor Subsidiaries would not be material to investors.
The non-guaranteeing subsidiaries represented less than 3% on an individual and aggregate basis of consolidated assets, pre-tax earnings, cash flow and equity. Therefore, the non-guarantor subsidiaries’ information is not separately presented in the tables below.
There are no current restrictions on the ability of the Guarantor Subsidiaries to make payments under the guarantees referred to above. The obligations of each guarantor under its guarantee are limited to the maximum amount permitted under Bankruptcy Law, the Uniform Fraudulent Conveyance Act, the Uniform Fraudulent Transfer Act, or any similar Federal or state law (e.g. laws requiring adequate capital to pay dividends) respecting fraudulent conveyance or fraudulent transfer.
The following tables present summarized financial information as of May 22, 2004, and January 31, 2004, and for the first quarters ended May 22, 2004 and May 24, 2003:
Condensed Consolidating
Balance Sheets
As of May 22, 2004
Cash, including temporary cash investments
Accounts receivable
Net inventories
Investment in and advances to subsidiaries
Total assets
Current portion of long-term debt including obligations under capital leases
Face value long-term debt including obligations under capital leases
Adjustment to reflect fair value interest rate hedges
Fair value interest rate hedges
Total liabilities
Shareowners’ Equity
Total liabilities and shareowners’ equity
As of January 31, 2004
Statements of Earnings
For the Quarter Ended May 22, 2004
Merchandise costs, including warehousing and transportation
Earnings (loss) from operations
Equity in earnings of subsidiaries
Earnings before tax expense
Tax expense (benefit)
For the Quarter Ended May 24, 2003
Merger-related costs, restructuring charges and related items
Statements of Cash Flows
Cash flows from investing activities:
Capital expenditures
Cash flows from financing activities:
Net change in advances to subsidiaries
Net cash provided (used) by financing activities
Net (decrease) increase in cash and temporary cash investments
Net used by financing activities
11. COMMITMENTS AND CONTINGENCIES
The Company continuously evaluates contingencies based upon the best available evidence.
Management believes that allowances for loss have been provided to the extent necessary and that its assessment of contingencies is reasonable. Allowances for loss are included in other current liabilities and other long-term liabilities. To the extent that resolution of contingencies results in amounts that vary from management’s estimates, future earnings will be charged or credited.
The principal contingencies are described below.
Insurance — The Company’s workers’ compensation risks are self-insured in certain states. In addition, other workers’ compensation risks and certain levels of insured general liability risks are based on retrospective premium plans, deductible plans, and self-insured retention plans. The liability for workers’ compensation risks is accounted for on a present value basis. The liability for general liability risks is not present-valued. Actual claim settlements and expenses incident thereto may differ from the provisions for loss.
Litigation — The Company is involved in various legal actions arising in the normal course of business. Although occasional adverse decisions (or settlements) may occur, the Company believes that the final disposition of such matters will not have a material adverse effect on the financial position or results of operations of the Company.
Assignments – The Company is contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. The Company could be required to satisfy obligations under leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of the Company’s assignments among third parties, and various other remedies available, the Company believes the likelihood that it will be required to satisfy a material amount of these obligations is remote.
Benefit Plans – The Company administers certain non-contributory defined benefit retirement plans for substantially all non-union employees and some union-represented employees as determined by the terms and conditions of collective bargaining agreements. Funding for the pension plans is based on a review of the specific requirements and an evaluation of the assets and liabilities of each plan.
In addition to providing pension benefits, the Company provides certain health care benefits for retired employees. Funding for the retiree health care benefits occurs as claims or premiums are paid.
The determination of the obligation and expense for the Company’s pension and other post-retirement benefits is dependent on the Company’s selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in the Company’s fiscal 2003 Annual Report on Form 10-K and include, among others, the discount rate, the expected long-term rate of return on plan assets, and the rates of increase in compensation and health care costs. Actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect the recognized expense and recorded obligation in such future periods. While the Company believes that the assumptions are appropriate, significant differences in actual experience or significant changes in assumptions may materially affect the pension and other post-retirement obligations and future expense.
In addition to the $100 contributed during the first quarter of 2003, the Company expects to make cash contributions to the company-sponsored pension plans in the current and upcoming years. The Company is required to make a cash contribution of $34 by September 15, 2004 and intends to contribute an additional $149 by that date. The Company expects the additional contributions made during 2004 will reduce its minimum required contributions in future years. Among other things, performance of plan assets, the interest rates required to be used to calculate the pension obligations and future changes in legislation, will determine the amounts of any additional contributions.
The Company also participates in various multi-employer pension plans for substantially all employees represented by unions. The Company is required to make contributions to these plans in amounts established under collective bargaining agreements. Pension expense for these plans is recognized as contributions are funded. Benefits are generally based on a fixed amount for each year of service. The Company contributed $169 to these plans in fiscal 2003. The Company would have contributed an additional $13 to these plans in 2003 had there been no labor disputes. Based on the most recent information available to the Company, it believes these plans continue to be underfunded. As a result, we expect that contributions to these plans will continue to increase and the benefit levels and related issues will continue to create collective bargaining challenges. Several of our recently completed labor agreements, including southern California, resulted in a reduction of liabilities and, therefore, a reduction of expected contribution increases. These multi-employer funds are managed by trustees, appointed by management of the employers (including Kroger) and labor in equal number, who
have fiduciary obligations to act prudently. Thus, while we expect contributions to these funds to continue to increase as they have in recent years, the amount of the increase will depend upon the outcome of collective bargaining, actions taken by trustees and the actual return on assets held in these funds. For these reasons, it is not practicable to determine the amount by which the Company’s multi-employer pension contributions will increase. Moreover, if the Company were to exit markets, it may be required to pay a withdrawal liability. Any adjustments for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated.
12. FAIR VALUE INTEREST RATE HEDGES
In the first quarter of 2003, the Company reconfigured a portion of its interest derivative portfolio by terminating six interest rate swap agreements that were accounted for as fair value hedges. Approximately $114 of proceeds received as a result of these terminations were recorded as adjustments to the carrying values of the underlying debt and are being amortized over the remaining lives of the debt. As of May 22, 2004, the unamortized balances totaled approximately $92.
During the first two quarters of 2003, the Company initiated 10 new interest rate swap agreements that are being accounted for as fair value hedges. As of May 22, 2004, liabilities totaling $22 have been recorded to reflect the fair value of these new agreements, offset by reductions in the fair value of the underlying debt.
13. DEBT OBLIGATIONS
During the first quarter of 2004, the Company executed a new five-year revolving credit facility, maturing in 2009 totaling $1,800. The new facility replaces the $1,000 364-Day and $812.5 Five-Year credit facilities.
14. SUBSEQUENT EVENTS
The United States Attorney’s Office for the Central District of California informed the Company that it is investigating the hiring practices of Ralphs Grocery Company during the labor dispute from October 2003 through February 2004. Among matters under investigation is the allegation that certain Ralphs store directors knowingly allowed or enabled some locked out employees to work under false identities or false Social Security numbers despite Company policy forbidding such conduct. A grand jury has convened to consider whether such acts violated federal criminal statutes. The Company is cooperating with the investigation, and it is too early to determine whether charges will be filed or what potential penalties Ralphs may face. In addition, these alleged practices are the subject of claims that Ralphs’ conduct of the lockout was unlawful, and that Ralphs should be liable under the National Labor Relations Act. The National Labor Relations Board has not determined to issue a complaint and, in any case, the Company believes it has substantial defenses to any such claims.
During the first week of the second quarter, Ralphs Grocery Company closed 14 stores. Liabilities related to the closing of these, and all other stores closed during the second quarter, will be recorded in the second quarter of 2004.
On June 4, 2004, the Company called its $750, 7.375% bonds, due in March 2005. The call will be funded on July 7, 2004. The Company expects to fund the call through a combination of available cash, commercial paper, and credit facility borrowings, and therefore has reclassified to long-term liabilities the debt that was called. The interest rate swap agreements related to these bonds will be terminated at that time.
During the second quarter, the Company successfully negotiated collective bargaining agreements with local unions representing its employees in Arizona and Detroit.
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following analysis should be read in conjunction with the Consolidated Financial Statements.
OVERVIEW
Kroger continues to grow its identical food-store sales and we expect to continue the improvement. Our investment in gross margin has been slower than originally planned as our divisions implement their sales plans. We are implementing these plans in a careful manner. We plan to continue making investments in pricing, customer service and product variety to deliver strong, sustainable sales growth. Our expectations for identical food-store sales in 2004, excluding fuel, continue to be higher than what we achieved in the fourth quarter of 2003. We continue to expect earnings in 2004 to be lower than in 2003, excluding the effect of labor disputes and unusual items. During the quarter, we successfully negotiated major collective bargaining agreements in southern California, Indiana, Houston and Memphis. Thereafter, agreements were ratified in Arizona and Detroit. We currently have indefinite contract extensions in Louisville, Seattle, Nashville and Food 4 Less in southern California, and votes currently are underway to ratify a tentative agreement in Nashville. For a more detailed discussion of our expectations and uncertainties related to those expectations, please see the “Outlook” section, below.
RESULTS OF OPERATIONS
Kroger’s first quarter 2004 financial results were adversely affected by labor disputes in southern California. These disputes, which are summarized below, adversely affected our sales, FIFO gross margin (as defined below) and operating, general and administrative expenses. Our analysis below includes estimates of the effects of these disputes on our first quarter, 2004 results in these areas.
Labor dispute summary – southern California
Safeway Inc., Albertson’s, Inc. and The Kroger Co., directly or through their subsidiaries, (collectively, the “Retailers”) are party to multi-employer bargaining with various local unions affiliated with the United Food and Commercial Workers International Union (“UFCW”) (collectively, the “Unions”) in southern California. The Retailers and the Unions entered into agreements under which a strike against one employer would be deemed a strike against all employers. In addition, the Retailers entered into an agreement among themselves (the “Agreement”) requiring, among other things, that if one employer were struck, the remaining employers would lock out bargaining unit employees. The Agreement was designed to prevent the Unions from placing disproportionate pressure on one or more of the Retailers by picketing one or more of the Retailers but not the others. The Agreement is more fully described below in “Other Items.” On October 11, 2003, the Unions initiated a strike against Safeway, Inc. On October 12, 2003, the other Retailers locked out the bargaining unit employees as required by the Agreement. On February 29, 2004, Kroger announced that it was notified by the UFCW that a new labor contract had been ratified by union members, ending a 141-day work stoppage.
Total sales for the first quarter of 2004 were $16.9 billion, an increase of 3.9% over total sales of $16.3 billion for the first quarter of 2003. Total food store sales increased 3.9% as well. The difference between total sales and total food store sales primarily relate to sales at convenience and jewelry stores and sales by manufacturing plants to outside firms.
We define a food store as an identical store in the quarter after the store has been in operation and has not been expanded or relocated for four full quarters. Differences between total food store sales and identical food store sales primarily relate to changes in food store square footage. Our identical food store sales results are summarized in the table below. The identical food store dollar figures presented were used to calculate first quarter 2004 percent changes.
Identical Food Store Sales
(In millions)
Including supermarket fuel centers
Excluding supermarket fuel centers
We define a food store as a comparable store in the quarter after the store has been in operation for four full quarters, including expansions and relocations. Our comparable food store sales results are summarized in the table below. The comparable food store dollar figures presented were used to calculate the first quarter 2004 percent changes.
Comparable Food Store Sales
While management believes that Kroger’s sales results are affected by product cost inflation and deflation, it is not practicable to segregate and to measure the effects of inflation and deflation on our retail prices because of changes in the types of merchandise sold during various periods and other pricing and competitive influences. For the first quarter of 2004, we estimate that our product cost inflation, including fuel, was 2.3% and, excluding fuel, was 1.6%, compared to the first quarter of 2003. We estimated that Kroger experienced product cost inflation, including fuel, was 0.0% and, excluding fuel, was 0.5% deflation for the first quarter of 2003 versus the first quarter of 2002.
Management was pleased with Kroger’s sales performance in the first quarter of 2004, especially in light of the continued difficult operating environment.
FIFO Gross Margin
We calculate First-In, First-Out (“FIFO”) Gross Margin as follows: Sales minus merchandise costs plus Last-In, First Out (“LIFO”) charge. Merchandise costs include advertising, warehousing and transportation, but exclude depreciation expenses and rent expense. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness.
Our FIFO gross margin rate declined 72 basis points to 26.01% for the first quarter of 2004 from 26.73% for the first quarter of 2003. Of this decline, the effect of fuel sales accounted for a 45 basis point reduction in our FIFO gross margin rate. The declining rate on non-fuel sales reflects our investment in lower retail prices, partially offset by our improvements in shrink.
The estimated effect of the labor dispute, more fully described in “Other Items,” further affected our FIFO gross margin rates.
Operating, General and Administrative Expenses
Operating, general and administrative (“OG&A”) expenses consist primarily of employee related costs such as wages, health care benefit costs and retirement plan costs. Among other items, rent expense, depreciation and amortization expense, and interest expense are not included in OG&A. OG&A expenses, as a percent of sales, increased 41 basis points to 19.04% for the first quarter of 2004 from 18.63% for the first quarter of 2003. Fuel sales decreased our OG&A rate increase from the first quarter of 2003 by 27 basis points.
The labor dispute adversely affected our first quarter 2004 OG&A results by an estimated $36.4 million, of which approximately $31.9 million related to the Agreement described above. All of the remaining increase in our OG&A rate related to increases in the cost of health care and pension benefits provided to our associates and their families.
Rent Expense
Rent expense, as a percent of total sales, was 1.23% and 1.22% in the first quarters of 2004 and 2003, respectively. The increase in rent expense was primarily related to an increase in closed store activity. We closed 22 stores in the first quarter of 2004 compared to 9 stores during the first quarter of 2003. We expect decreases in our rent expense as a percent of total sales, excluding closed-store activity, reflecting the emphasis our current growth strategy places on ownership of real estate.
Depreciation Expense
Depreciation expense, as a percent of total sales, was 2.20% and 2.18% in the first quarters of 2004 and 2003, respectively. The increases in depreciation expense, as a percent of sales, result primarily from Kroger’s capital investment program and its emphasis on ownership of real estate.
Interest Expense
Interest expense, as a percent of total sales, was 1.02% and 1.17% in the first quarters of 2004 and 2003, respectively. The reduction in interest expense, as a percent of total sales, for 2004, when compared to 2003, reflects lower variable rate borrowings in 2004 as well as an overall reduction of total debt.
Income Taxes
Assuming the Work Opportunity Tax Credit is not re-established, we expect the effective tax rate for fiscal 2004 will be in the range of 38.0%. Our effective income tax rate was 36.9 % for the first quarter of 2004 and 37.5% for the first quarter of 2003. The effective income tax rates differ from the federal statutory rate primarily due to the effect of state taxes and open items with various taxing authorities.
Net Earnings
Net earnings totaled $263 million, or $0.35 per diluted share, in the first quarter of 2004. These results represent a decrease of 25.3% from net earnings of $352 million, or $0.46 per diluted share for the first quarter of 2003. Results in both quarters include the items described below in “Other Items.” Those items totaled approximately $0.10 of after-tax expense per diluted share in the first quarter of 2004, consisting entirely of the estimated effects of the labor disputes, compared to $.01 of after-tax income per diluted share in the first quarter of 2003.
OTHER ITEMS
The following table summarizes items that affected Kroger’s financial results during the periods presented. These items should not be considered alternatives to net earnings, net cash provided by operating activities or any other Generally Accepted Account Principle (“GAAP”) measure of performance or liquidity. These items should not be viewed in isolation or considered substitutes for Kroger’s results as reported in accordance with GAAP. Due to the nature of these items, as described below, it is important to identify these items and review them in conjunction with Kroger’s financial results reported in accordance with GAAP.
These items include the estimated effect of the southern California labor dispute as well as charges and credits that were recorded as components of OG&A expense.
(In millions except per share amounts)
Items affecting FIFO gross margin (1)
Estimated effect of labor disputes
Total affecting FIFO gross margin
Items affecting OG&A
Mutual strike assistance agreement
Energy purchase commitments – market value adjustment
Reduction of lease liabilities – store closing plans
Total affecting OG&A
Total pre-tax income (loss)
Income tax effect
Total after-tax income (loss)
Diluted shares
Estimated diluted per share income (loss)
Items Affecting FIFO Gross Margin and Operating, General and Administrative Expense
Estimated Effect of Labor Disputes
In prior quarters, we estimated the effect of labor disputes by comparing actual results to internal projections and forecasts prepared prior to the labor dispute. Since the labor dispute continued into 2004, we did not have a current projection without the labor dispute for the first quarter and instead used our 2004 budgets. Our 2004 budgets were prepared taking into consideration economic and competitive conditions, as well as changes in our business plan strategies, but assuming the strike had not occurred. Based on those budgets, the estimated effects included the difference between reported sales and sales budgets less reported merchandising costs and budgeted merchandising cost and the difference between reported OG&A and budgeted OG&A expenses.
Differences affecting FIFO gross margin included incremental warehousing, distribution, advertising and inventory shrinkage expenses incurred during the labor dispute, as well as the investment in FIFO gross margin, through targeted retail price reductions, and advertising in order to regain our sales during the post-strike recovery period. Differences in OG&A included costs associated with hiring and training replacement workers, costs associated with bringing in employees from other Kroger divisions to work on a temporary basis, expenses under the Agreement and costs related to hiring and training workers to replace union members who did not return to work after the labor dispute ended.
As described above in “Results of Operations,” the Agreement entered into in connection with the multi-employer collective bargaining agreement among the Retailers was designed to prevent the Unions from placing disproportionate pressure on one or more of the Retailers by picketing one or more of the Retailers but not the others. The Agreement provided for payments from any of the Retailers who gained from such disproportionate pressure to any of the Retailers who suffered from such disproportionate pressure, based on a percentage of the sales deemed caused by the disproportionate pressure. Expenses related to the Agreement were recorded as OG&A and totaled approximately $32 million, pre-tax, during the first quarter of 2004.
Lease liabilities – Store closing plans
In connection with the 2001 asset impairment review described below, we recorded pre-tax OG&A expenses of $20 million in 2001 for the present value of lease liabilities for the leased stores identified for closure. In 2000, we also recorded pre-tax expenses of $67 million for the present value of lease liabilities for similar store closings. The 2000 liabilities pertained primarily to stores acquired in the Fred Meyer merger, or to stores operated prior to the merger that were in close proximity to stores acquired in the merger, that were identified as under-performing stores. In both years, liabilities were recorded for the planned closings of the stores.
Due to operational changes, performance improved at five stores that had not yet closed. As a result of this improved performance, in the first quarter of 2003 we modified our original plans and determined that these five locations will remain open. Additionally, closing and exit costs at other locations included in the original plans were less costly than anticipated.
In total, in the first quarter of 2003, we recorded pre-tax income of $10 million to adjust these liabilities to reflect the outstanding lease commitments at the locations remaining under the plans. Sales at the stores remaining under the plans totaled $41 million and $43 million for the rolling four-quarter periods ended May 22, 2004, and May 24, 2003, respectively. Net operating income or loss for these stores cannot be determined on a separately identifiable basis.
Energy purchase commitments
During March through May 2001, we entered into four separate commitments to purchase electricity from Dynegy, Inc. (“Dynegy”) in California. At the inception of the contracts, forecasted electricity usage indicated that it was probable that all of the electricity would be utilized in our operations. We, therefore, accounted for the contracts in accordance with the normal purchases and normal sales exception under Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, and no amounts were initially recorded in the financial statements related to these purchase commitments.
During the third quarter of 2001, we determined that one of the contracts, and a portion of a second contract, provided for supplies in excess of our expected demand for electricity. This precluded use of the normal purchases and normal sales exception under SFAS No. 133 for those contracts, and required the contracts to be marked to fair value through current-period earnings. We, therefore, recorded a pre-tax charge of $81 million in the third quarter of 2001 to accrue liabilities for the estimated fair value of these contracts through the December 2006 ending date of the commitments. We re-designated the remaining portion of the second contract as a cash flow hedge of future purchases under the contract. The other two purchase commitments continued to qualify for the normal purchases and normal sales exception under SFAS No. 133 through June 2003.
SFAS No. 133 required the excess contracts to be marked to fair value through current-period earnings each quarter. In the first quarter of 2003, we recorded a pre-tax charge of $3 million to mark the excess contracts to fair value as of May 24, 2003.
On July 3, 2003, we reached an agreement through which we ended supply arrangements with Dynegy in California related to these four power supply contracts. The Federal Energy Regulatory Commission approved the settlement agreement on July 23, 2003. On August 27, 2003, we paid $107 million, before the related tax benefits, to settle disputes with Dynegy related to prior over-payments, terminate two of the four contracts effective July 6, 2003, and terminate the remaining two agreements effective September 1, 2003. As a result of the settlement, we recorded $62 million of pre-tax expense in the second quarter of 2003.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Information
We generated $941 million of cash from operating activities during the first quarter of 2004 compared to $933 million during the first quarter of 2003. Our decrease in net earnings was offset by decreases in store deposits in-transit and the use of cash to decrease accrued expense. In addition, during the first quarter of 2003, we made a cash contribution of $100 million to our Company sponsored pension plan.
Investing activities used $447 million of cash during the first quarter of 2004 compared to $656 million during the first quarter of 2003. The amount of cash used by investing activities decreased in 2004 versus 2003 due to the buyout of a synthetic lease totaling $202 million in 2003.
Financing activities used $510 million of cash in the first quarter of 2004 compared to $292 million in the first quarter of 2003. The increase in the amount of cash used was cause by a reduction of $79 million in the amount of book overdrafts and proceeds totaling $114 million received during the first quarter of 2003 for the termination of several interest rate swap agreements. We used a net of $321 million to reduce outstanding debt during the first quarter of 2004 compared to $336 million during the first quarter of 2003.
Debt Management
On May 21, 2004, we announced we had executed a new five-year revolving credit facility totaling $1.8 billion. The new facility replaces our $1.0 billion 364-day and $812.5 million five-year credit facilities. In addition to the new $1.8 billion credit facility, maturing in 2009, we continue to maintain a $700 million five-year credit facility that matures in 2007. Outstanding credit agreement and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit facilities. In addition, we had a $75 million money market line, borrowings under which also reduce the funds available under the credit facilities. As of May 22, 2004, our outstanding credit agreement and commercial paper borrowings totaled $95 million. We had no borrowings under the money market line as of May 22, 2004. The outstanding letters of credit that reduced the funds available under the credit facility totaled $255 million at such time.
As of May 22, 2004, we also had a $100 million pharmacy receivable securitization facility that provided capacity incremental to the $2.5 billion described above. Funds received under this $100 million facility do not reduce funds available under the Credit Facilities. Collection rights to some of Kroger’s pharmacy accounts receivable balances are sold to initiate the drawing of funds under the facility. As of May 22, 2004, we had no borrowings under the pharmacy receivable securitization facility.
Our bank credit facilities and the indentures underlying our publicly issued debt contain various restrictive covenants. As of May 22, 2004, we were in compliance with these financial covenants. Furthermore, management believes it is not reasonably likely that Kroger will fail to comply with these financial covenants in the foreseeable future.
Total debt, including both the current and long-term portions of capital leases, decreased $258 million to $8.0 billion as of the end of the first quarter of 2004, from $8.3 billion as of the end of the first quarter of 2003. Total debt decreased $350 million as of the end of the first quarter of 2004 from $8.4 billion as of year-end 2003. The decreases in 2004 resulted from the use of cash flow from operations to reduce outstanding debt and lower mark-to-market adjustments.
On June 4, 2004, we called a $750 million, 7.375% bond issuance due in March 2005. The call will be funded on July 7, 2004, and is expected to be funded through a combination of available cash, commercial paper, and credit facility borrowings. Based on current interest rates, we expect to incur a premium of approximately $26 million and anticipate a reduction in interest expense of approximately $21 million for the current year.
Common Stock Repurchase Program
During the first quarter of 2004, we invested $149 million to repurchase 9.0 million shares of Kroger stock at an average price of $16.62 per share. These shares were reacquired under two separate stock repurchase programs. The first is a $500 million repurchase program that was authorized by Kroger’s Board of Directors in December of 2002. The second is a program that uses the cash proceeds from the exercises of stock options by participants in Kroger’s stock option and long-term incentive plans as well as the associated tax benefits. In the first quarter of 2004, we purchased approximately 7.3 million shares, totaling $121 million, under our $500 million stock repurchase program and we purchased an additional 1.7 million shares, totaling $28 million, under our program to repurchase common stock funded by the proceeds and tax benefits from stock option exercises. As of May 22, 2004, we had $39 million remaining under the $500 million authorization.
CAPITAL EXPENDITURES
Capital expenditures excluding acquisitions totaled $453 million for the first quarter of 2004 compared to $664 million for the first quarter of 2003. Expenditures in the first quarter of 2003 included purchases of assets totaling $202 which were previously financed under a synthetic lease.
During the first quarter of 2004, we opened, acquired, expanded or relocated 32 food stores and also completed 42 within-the-wall remodels. In total, we operated 2,536 food stores at the end of the first quarter of 2004 versus 2,496 food stores in operation at the end of the first quarter of 2003. Total food store square footage increased 2.4% over the first quarter of 2003.
RECENTLY ISSUED ACCOUNTING STANDARDS
FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” was issued in January of 2003 and revised in December 2003. FIN 46 provides guidance relating to the identification of, and financial reporting for, variable-interest entities, as defined in the Interpretation. FIN 46 is effective for all variable-interest entities created after January 31, 2003. For any variable-interest entities created prior to February 1, 2003, FIN 46 became effective on February 1, 2004, the beginning of the our first quarter of 2004, unless earlier adopted, except for entities designated as special purpose entities for which the effective date was the fourth quarter of 2003. In the fourth quarter of 2003, we adopted FIN 46 for an unaffiliated mortgagor of certain of our properties.
In May 2004, the FASB issued Staff Position (“FSP”) No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” FSP No. 106-2 supersedes FSP No. 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” and provides guidance on the accounting disclosure, disclosure and transition related to the Prescription Drug Act. FSP No. 106-2 will be effective for the first interim period beginning after June 15, 2004. We will continue to investigate the effect of FSP No. 106-2’s initial recognition, measurement and disclosure requirements on our Consolidated Financial Statements, however, we do not expect adoption of FSP No. 106-2 to have a material effect on our Consolidated Financial Statements.
In November 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-10, “Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers.” Issue No. 03-10 addresses the accounting for manufacturer sales incentives offered directly to consumers, including manufacturer coupons. EITF Issue No. 03-10 became effective for Kroger on February 1, 2004, the beginning of our first quarter of 2004. Adoption of EITF Issue No. 03-10 reduced our sales and merchandise costs by $17.9 during the first quarter of 2004. We expect adoption of EITF Issue No. 03-10 will have similar effects in future quarters.
OUTLOOK
This discussion and analysis contains certain forward-looking statements about Kroger’s future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available. Such statements relate to, among other things: projected change in net earnings; identical sales growth; expected pension plan contributions; our ability to generate operating cash flow; projected capital expenditures; square footage growth; opportunities to reduce costs; cash flow requirements; and our operating plan for the future; and are indicated by words or phrases such as “comfortable,” “committed,” “expect,” “goal,” “should,” “target,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially.
Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21 E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially from those statements.
Various uncertainties and other factors could cause us to fail to achieve our goals. These include:
We cannot fully foresee the effects of changes in economic conditions on Kroger’s business. We have assumed economic and competitive situations will not change significantly for 2004.
Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in or contemplated or implied by forward-looking statements made by us or our representatives.
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.
There have been no other significant changes in our exposure to market risk from the information provided in Item 7A. Quantitative and Qualitative Disclosures About Market Risk on our Form 10-K filed with the SEC on April 14, 2004.
ITEM 4. Controls and Procedures.
The Chief Executive Officer and the Chief Financial Officer, together with a disclosure review committee appointed by the Chief Executive Officer, evaluated Kroger’s disclosure controls and procedures as of the quarter-ended May 22, 2004. Based on that evaluation, Kroger’s Chief Executive Officer and Chief Financial Officer concluded that Kroger’s disclosure controls and procedures were effective as of the end of the period covered by this report.
In connection with the evaluation described above, there was no change in Kroger’s internal control over financial reporting during the quarter-ended May 22, 2004, that has materially affected, or is reasonably likely to materially affect, Kroger’s internal control over financial reporting.
PART II - OTHER INFORMATION
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
(e)
Period (1)
MaximumDollar Value ofShares that MayYet BePurchasedUnder the Plansor Programs (3)
(in millions)
First four weeks
February 1, 2004 to February 28, 2004
Second four weeks
February 29, 2004 to March 27, 2004
Third four weeks
March 28, 2004 to April 24, 2004
Fourth four weeks
April 25, 2004 to May 22, 2004
Total
Item 6. Exhibits and Reports on Form 8-K.
(a)
EXHIBIT 3.1 - Amended Articles of Incorporation of the Company are hereby incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended October 3, 1998. The Company’s Regulations are incorporated by reference to Exhibit 4.2 of the Company’s Registration Statement on Form S-3 as filed with the Securities and Exchange Commission on January 28, 1993, and bearing Registration No. 33-57552.
EXHIBIT 4.1 - Instruments defining the rights of holders of long-term debt of the Company and its subsidiaries are not filed as Exhibits because the amount of debt under each instrument is less than 10% of the consolidated assets of the Company. The Company undertakes to file these instruments with the Commission upon request.
EXHIBIT 31.1 – Rule 13a–14(a) / 15d–14(a) Certifications – Chief Executive Officer
EXHIBIT 31.2 – Rule 13a–14(a) / 15d–14(a) Certifications – Chief Financial Officer
EXHIBIT 32.1 – Section 1350 Certifications
EXHIBIT 99.1 - Additional Exhibits - Statement of Computation of Ratio of Earnings to Fixed Charges.
(b)
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: July 1, 2004
By:
/s/ David B. Dillon
David B. Dillon
Chairman and
Chief Executive Officer
/s/ J. Michael Schlotman
J. Michael Schlotman
Senior Vice President and
Chief Financial Officer
Exhibit Index